16.5 Choosing between Projects
4 min read•june 18, 2024
Evaluating investment projects is crucial for maximizing shareholder value. Companies must compare using net present value (NPV) to determine financial viability. The highest positive NPV project typically gets the green light, as it's expected to generate the most wealth.
When dealing with capital constraints, prioritization becomes key. Companies rank projects based on metrics like NPV or to identify top opportunities. Allocating capital to the highest-ranking projects ensures optimal resource use, maximizing overall portfolio value within budget limitations.
Evaluating and Selecting Investment Projects
Investment project selection
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- are investment opportunities that cannot be pursued simultaneously (opening a new store in either New York or Los Angeles)
- Accepting one project means rejecting the other(s)
- Compare the net present value (NPV) of each project to determine which one is more financially viable
- NPV is the sum of all future cash flows discounted to the present value, taking into account the
- Formula:
- = cash flow at time (revenue, expenses, etc.)
- = discount rate (cost of capital or required rate of return)
- = number of periods (years, months, or quarters)
- Select the project with the highest positive NPV, as it indicates the project is expected to increase shareholder value and generate the most wealth
- A positive NPV suggests that the project's discounted cash inflows exceed its discounted cash outflows
- If all projects have negative NPVs, reject all of them, as they are expected to decrease shareholder value and result in a financial loss
- Consider the , which represents the additional cash flow generated by accepting a project
Equivalent annual cost analysis
- When comparing projects with different lifespans, use the (EAC) or (EAB) method to make a fair comparison
- EAC converts the NPV of a project into an annuity over the project's lifespan, representing the annual cost of owning and operating an asset
- Formula:
- = net present value of the project
- = discount rate (cost of capital or required rate of return)
- = number of periods (years, months, or quarters)
- Formula:
- EAB is similar to EAC but uses the project's benefits instead of costs, representing the annual benefit generated by the project
- Select the project with the lowest EAC or highest EAB, as it indicates the most cost-effective or beneficial option on an annual basis (comparing a 5-year project with a 10-year project)
Scale comparison of investments
- When comparing projects of different sizes or scales, use the (PI) to assess their relative profitability
- PI is the ratio of the present value of future cash flows to the initial investment, indicating the amount of value created per unit of investment
- Formula:
- A PI greater than 1 indicates that the project is expected to be profitable, as the present value of future cash flows exceeds the initial investment
- Rank projects based on their PI and select the project with the highest PI, as it offers the highest profitability relative to the investment required (comparing a 5 million project)
Managing Capital Constraints
Project prioritization under constraints
- When a company has limited capital or resources, it must prioritize projects based on their financial and strategic merits
- Rank projects based on their NPV, PI, or other relevant metrics (IRR, ) to identify the most attractive opportunities
- Allocate capital to projects with the highest rankings until the budget is exhausted, ensuring that the most valuable projects are funded first
- Consider the project's , strategic fit (alignment with company goals), and other qualitative factors in addition to financial metrics
- Use techniques to optimize the allocation of limited resources and maximize the overall value of the project portfolio
- Capital rationing involves selecting a combination of projects that maximizes the total NPV while staying within the budget constraint (knapsack problem)
- Calculate the NPV and initial investment for each project
- Rank projects based on their PI (NPV divided by initial investment)
- Select projects with the highest PI until the budget is exhausted
Additional Considerations in Project Selection
- : The value of the next best alternative that is foregone when choosing a particular project
- Time value of money: The concept that money available now is worth more than the same amount in the future due to its potential earning capacity
- Risk-adjusted return: The potential return on an investment, adjusted for the level of risk associated with that investment
- Incremental cash flow: The additional cash flow generated by accepting a project, considering only the difference between cash flows with and without the project
Key Terms to Review (33)
2014 Winter Olympics: The 2014 Winter Olympics, officially known as the XXII Olympic Winter Games, were held in Sochi, Russia. This major international sporting event involved significant financial investments and strategic planning by both public and private entities.
Capital Budgeting: Capital budgeting is the process of evaluating and selecting long-term investments or projects that are expected to generate returns for a business over multiple years. It involves analyzing the costs, risks, and potential benefits of various investment options to determine the most advantageous use of a company's limited financial resources.
Capital Rationing: Capital rationing is the process of allocating a limited amount of capital or financial resources to the most profitable and viable investment projects within an organization. It is a critical decision-making tool used to optimize the use of available funds and maximize the return on investment.
COVID-19: COVID-19 is a global pandemic caused by the novel coronavirus SARS-CoV-2, significantly impacting economic activities and financial markets. It has led to disruptions in supply chains, market volatility, and changes in consumer behavior, affecting corporate financial health and investment decisions.
Crossover Rate: The crossover rate is a key concept in the context of choosing between projects. It represents the discount rate at which the net present values (NPVs) of two mutually exclusive projects are equal, indicating the point where the decision-maker is indifferent between the two projects.
Discounted Cash Flow: Discounted cash flow (DCF) is a valuation method used to estimate the present value of a company's future cash flows. It is a fundamental concept in finance that considers the time value of money, where future cash flows are discounted to their present worth using an appropriate discount rate.
Discounted cash flow (DCF): Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. The future cash flows are adjusted for the time value of money using a discount rate.
Discounted payback period: The discounted payback period is the time it takes for an investment to generate cash flows sufficient to recover its initial cost, accounting for the time value of money. It provides a more accurate assessment of an investment's profitability compared to the traditional payback period by discounting future cash flows.
Equal annuity approach: The equal annuity approach is a method for comparing investment projects by converting their net present value (NPV) into equivalent annual amounts. This allows for easy comparison of projects with different lifespans and cash flow patterns.
Equivalent Annual Benefit: The equivalent annual benefit (EAB) is a measure used in capital budgeting to compare the relative value of different projects or investments. It represents the equal annual cash flow that would provide the same net present value (NPV) as the uneven cash flows of a project over its lifetime.
Equivalent Annual Cost: Equivalent Annual Cost (EAC) is a financial analysis technique used to compare the long-term costs of different projects or investment alternatives. It converts the total lifetime costs of a project into an equal annual payment, allowing for an apples-to-apples comparison between options with varying lifespans or cost structures.
Fisher Separation Theorem: The Fisher separation theorem states that the optimal investment decision and the optimal consumption decision can be made independently of each other. It separates the investment decision from the consumption decision, allowing investors to focus on maximizing the value of their investments without being constrained by their personal consumption preferences.
Incremental Cash Flow: Incremental cash flow refers to the change in cash flow that results from a specific business decision or project. It represents the additional or marginal cash inflows and outflows associated with implementing a new initiative, compared to the existing situation or alternative options.
Independent Projects: Independent projects are investment opportunities that do not compete with each other, meaning the acceptance of one project does not affect the others. This characteristic allows organizations to evaluate each project on its own merits and make decisions based solely on the expected cash flows and profitability, rather than having to choose between mutually exclusive options.
Internal rate of return (IRR): Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It is used to evaluate the profitability of potential investments.
McKinsey & Company: McKinsey & Company is a global management consulting firm that provides strategic advice to corporations, governments, and other organizations. It is known for its expertise in helping companies make decisions on investments and managing projects effectively.
Mutually exclusive projects: Mutually exclusive projects are investment opportunities where the acceptance of one project necessitates the rejection of another. This is due to constraints such as budget, resources, or strategic alignment.
Mutually Exclusive Projects: Mutually exclusive projects are a set of projects where the selection of one project precludes the selection of the other projects in the set. In other words, only one project from the set can be chosen and implemented at a time due to resource constraints or incompatibility between the projects.
NPV Profile: The NPV (Net Present Value) Profile is a graphical representation that depicts the relationship between the NPV of a project and the discount rate used in the NPV calculation. It provides a visual tool for analyzing and comparing the financial viability of different investment projects.
Opportunity cost: Opportunity cost is the value of the next best alternative that is forgone when making a decision. It represents the benefits you could have received by taking an alternative action.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-offs involved in allocating limited resources to one use instead of another.
Payback Period: The payback period is a metric used to evaluate the time it takes for an investment or project to recoup its initial cost through the generated cash flows or savings. It is a commonly used method to assess the viability and risk of a potential investment by determining how quickly the investment can be recovered.
Profitability Index: The Profitability Index, also known as the Benefit-Cost Ratio, is a metric used to evaluate the profitability and viability of a project or investment. It compares the present value of a project's expected future cash inflows to the present value of its initial investment or costs, providing a measure of the project's return on investment.
Profitability index (PI): Profitability Index (PI) measures the ratio of the present value of future cash flows to the initial investment. It is used to assess the attractiveness of an investment.
Replacement chain approach: The replacement chain approach is a method used in capital budgeting to compare projects with different lifespans by repeating shorter projects until they match the duration of longer projects. This technique ensures a fair comparison of the net present value (NPV) over an equivalent time period.
Risk-adjusted return: Risk-adjusted return is a measure of the return on an investment or portfolio, adjusted for the amount of risk taken to achieve that return. It allows for a more meaningful comparison of investments with different risk profiles by accounting for the level of risk inherent in each investment.
Scenario analysis: Scenario analysis is a process of evaluating possible future events by considering alternative plausible scenarios. It helps in understanding the impact of different variables on financial outcomes.
Scenario Analysis: Scenario analysis is a strategic planning technique that involves the examination of potential future events or outcomes by considering alternative possible scenarios. It is a tool used to assess the impact of various factors on a company's performance and decision-making process.
Sensitivity analysis: Sensitivity analysis examines how the variation in input variables affects outcomes in a financial model. It helps identify which variables have the most significant impact on cash flow and growth projections.
Sensitivity Analysis: Sensitivity analysis is a technique used to determine how the output or outcome of a financial model or decision-making process is affected by changes in the values of the input variables or assumptions. It allows decision-makers to understand the impact of uncertainty and identify the key drivers that influence the final result.
Sochi, Russia: Sochi is a city in Russia located on the Black Sea coast, known for hosting the 2014 Winter Olympics. It serves as a significant hub for tourism, sports events, and international conferences.
Time Value of Money: The time value of money is a fundamental concept in finance that recognizes the difference in value between a sum of money available today and the same sum available at a future point in time. It is based on the principle that money available at the present time is worth more than the identical sum in the future due to its potential to earn interest or be invested to generate a return.
Time value of money (TVM): Time Value of Money (TVM) is the concept that money available now is worth more than the same amount in the future due to its potential earning capacity. This principle underlines why receiving money today is preferable to receiving it later.